a. In his General Theory, Keynes argues that wages and prices
are sticky in the short run, with the result that the supply may
not be equal to demand in each market at each point of time. This
explains the business cycles in the economy and according to Keynes
the government should intervene in the markets through fiscal and
monetary policy to smooth out the business cycles.

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Step 2 of 12

To formulate the new-Keynesian model we assume that

• All firm charge the price P for goods in the current period
and price is sticky and will not move during the period in response
to change in demand for goods.

• The inflation rate is a constant or zero so that the nominal
interest rate is equal to real interest rate.

• The output demand curve gives the goods market equilibrium and
is typically called the IS curve.

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Step 3 of 12

We display the basic new Keynesian model in the figure 1 below,
with money market in right panel, where demand for money is a
function of income and interest rate and money supply is fixed. In
the left panel we show goods market equilibrium with
Yd1 gives the demand for goods and
Ys1 gives the supply of goods.

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Step 4 of 12

Figure

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Step 5 of 12

Initially we start with an economy where an unanticipated shock
has hit the economy. The price level in the money market panel
initially was P1 and is greater than the equilibrium
price level in the goods market. Similarly, the central bank’s
interest rate target was too high so there is a positive output gap
which is less than the output firm wants to supply at the price
level P1 and interest rate target r1.

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Step 6 of 12

Suppose that in response to the shock the government increases
the government spending by the right amount which shifts the output
demand curve from Yd1 to
Yd2. The increase in spending increases the
aggregate demand. The government spending increases present value
of taxes and decreases leisure. This increases the aggregate supply
and the supply curve increases from Ys1 to
Ys2. Both these increases aggregate income to
Y2 but keep the interest rate unchanged at
r1. As the interest rate does not change, the investment
and consumption remain unchanged. Also a change in income increases
the demand for money from PL (Y1, r1) to PL
(Y2, r2); as prices are sticky, the monetary
authority increases money supply from M1 to
M2 to maintain its interest rate target.

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Step 7 of 12

b. In his General Theory, Keynes argues that wages and prices
are sticky in the short run, with the result that the supply may
not be equal to demand in each market at each point of time. This
explains the business cycles in the economy and according to Keynes
the government should intervene in the markets through fiscal and
monetary policy to smooth out the business cycles.

Provide feedback (0)

Step 8 of 12

To formulate the new-Keynesian model we assume that

• All firm charge the price P for goods in the current period
and price is sticky and will not move during the period in response
to change in demand for goods.

• The inflation rate is a constant or zero so that the nominal
interest rate is equal to real interest rate.

• The output demand curve gives the goods market equilibrium and
is typically called the IS curve.

Provide feedback (0)

Step 9 of 12

We display the basic new Keynesian model in the figure 1 below,
with money market in right panel, where demand for money is a
function of income and interest rate and money supply is fixed. In
the left panel we show goods market equilibrium with
Yd1 gives the demand for goods and
Ys1 gives the supply of goods.

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Step 10 of 12

Figure 1

Initially we start with an economy where an unanticipated shock
has hit the economy. The price level in the money market panel
initially was P1 and is greater than the equilibrium
price level in the goods market. Similarly, the central bank’s
interest rate target was too high so there is a positive output gap
which is less than the output firm wants to supply at the price
level P1 and interest rate target r1.

Provide feedback (0)

Step 11 of 12

Suppose that in response to the shock the government increases
the government spending by the right amount which shifts the output
demand curve from Yd1 to
Yd2. The increase in spending increases the
aggregate demand. The government spending increases present value
of taxes and decreases leisure. This increases the aggregate supply
and the supply curve increases from Ys1 to
Ys2. Both these increases aggregate income to
Y2 but keep the interest rate unchanged at
r1. As the interest rate does not change, the investment
and consumption remain unchanged. Also a change in income increases
the demand for money from PL (Y1, r1) to PL
(Y2, r2); as prices are sticky, the monetary
authority increases money supply from M1 to
M2 to maintain its interest rate target.

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Step 12 of 12

Here we see that under unanticipated shock an increase in
government spending increases output. The increase in output does
not change the investment, consumption and the price level or the
interest rate in the economy. It only increases the real income
need to close the output gap due to unanticipated shock. Thus, the
government spending shock does not produce a business cycle.